Last night, Bloomberg reported that the Basel Committee was considering revising Basel III's new Liquidity Coverage Ratio (LCR) to allow banks to use equities in their liquidity pools. This would be a relatively major change, and one which I consider ill-advised. (For background, I've written about the LCR severaltimesbefore.) From Bloomberg:

"The Basel Committee on Banking Supervision, which coordinates regulations for 27 countries, may let banks use equities and more corporate debt, in addition to cash and sovereign bonds, to satisfy new short-term liquidity standards, said two people with direct knowledge of the plans who requested anonymity because the talks are private."

At a Senate Banking hearing today, Fed Governor Dan Tarullo confirmed this report. He also indicated that the Fed would support expanding the list of assets that are eligible for the LCR's liquidity pool. Here's Tarullo after being asked about the Bloomberg report (from the CQ transcript of the hearing):

We — which is to say the Federal Reserve — was one of the entities which asked internationally to take another look at liquidity coverage ratio.
...
And one of the — one of the precepts, I think, for the — for the renewed look was just the point that you were making, that if you're worried about the liquidity of a firm, what you're really asking is, how well is the liabilities and the assets of that firm matched so that in a period of stress it can cover its needs in a — over some period of time so that it has a plan for — it can develop a plan for longer run survival.

And what I have thought was that the 2008 period gave us a very good real life experiment to test what kinds of instruments actually do remain liquid even during a period of stress like that. For example, highly traded equities of large companies.

So that is in fact one of the motivations for the rethink, and I believe that once the international group at the Basel Committee that's looking at the LCR has finished its evaluation next year, that you will see some changes in things like what qualifies in assumed run rates and the like, to try to conform the requirements somewhat more closely to the experience we actually had in late [2008].

Tarullo, therefore, seems to be willing to allow banks to use certain large-cap equities in their liquidity pools. (Basel III's LCR requires banks to maintain large liquidity pools, which must be made up of "high quality liquid assets," so technically what Tarullo is saying is that certain large-cap equities should be included in the definition of "high quality liquid assets.")

Two points here. First, there's a reason that most banks don't currently include equities in their liquidity pools, and that the Fed applies higher haircuts to equities in its emergency lending operations. The reason is that equities are typically more volatile than other instruments (e.g., fixed-income). Allowing banks to use equities in their liquidity pools increases the risk that a bank will have a large shortfall in its liquidity pool on a given day. Presumably, if the Basel Committee makes this change, equities would be categorized as "Level 2" high quality liquid assets (which I explained here), which means a 15% haircut would be applied. But does anyone honestly believe that a 15% haircut is enough for equities — especially given the wild swings in the equity markets that we witnessed even in 2008? I'm not at all convinced that there's a large class of equities that would be truly liquid in a crisis, and certainly not a large enough class to justify the inclusion of equities in banks' liquidity pools.

Second, I'm disappointed to see Tarullo endorse the argument that we can determine which assets are truly liquid by looking at how they fared in the 2008 crisis. As I've noted before, this is a really stupid argument. It may be true that certain large-cap equities maintained their liquidity throughout the 2008 crisis, but there were also massive government bailouts in 2008 — not to mention the extraordinary amounts of liquidity that the Fed pumped into the financial system.

How much did those large-cap equities that Tarullo refers to rely on the Fed's extraordinary lending programs (directly and indirectly) to maintain their liquidity? The point of the LCR is to ensure that banks can survive a funding crisis without massive government bailouts. Contra Tarullo, 2008 is NOT a very good — or even an appropriate — guide. Regulators will simply have to accept that determining which assets are likely to remain liquid in a TARP-free crisis will require the application of judgment on their part.

This is a development worth watching.

477
comments:

I don't think it's settled at all that the purpose of LCR is to allow the banks to survive a systemic crisis, rather than an idiosyncratic shock. This was a major theme of the consultation responses. It kind of goes to the heart of whether LCR is actually a coherent regulatory approach; what does it even mean for there to be a funding crisis, which all the banks have sufficient funding to survive?

I don't think it was ever intended that the LCR was meant to implement narrow-banking, and therefore it was always implicitly assumed that there would still be a role for central bank emergency operations under LCR. In that case, it makes more sense to ask what remains liquid in market conditions including central bank operations, not some in-principle, never-observed question of what might be the case if the central banks left the whole market to go to hell.

Even then, I have to note that the equity market performed a lot better than many others during the period between the Lehman bankruptcy and the agreement of TARP. There wasn't a day on which you couldn't have shifted a portfolio of large-cap equities for 85% of the previous day's close. That's not true of, for example, 90 day commercial paper.

The real mistake here (and I talk as someone who's done liquidity regulation, fifteen years ago) is to take a really complicated and subtle activity, and try to turn it into a ratio.

Given examples of equity indices dropping more than 30% in a day (eg in 1987) an appropriate haircut for portfolios of equities could not be less than a significant multiple eg 2-3 times this level. For individual equities the multiple should be higher as drops of 90% are not uncommon (if bankruptcy becomes an issue). Hence I would suggest the appropriate haircut be 90-98% depending on the diversity of the equity portfolio.Not much benefit there!Rupi

Presumably, if the Basel Committee makes this change, equities would be categorized as "Level 2" high quality liquid assets (which I explained here), which means a 15% haircut would be applied.

If the BCBS were to allow equities into the numerator of the LCR, they would not be added as a Level 2 asset, but would be part of some lower class of asset. The haircut would probably be somewhere in line with those found in Table 1 of the 2010 CGFS paper on "The Role of Margin Requirements and Haircuts in Procycliality" (http://www.bis.org/publ/cgfs36.pdf). As well, the 30-day volatility of major indices seen during this crisis are at or below the volatility of many Sovereign bond indices.

However I fully agree with the author that 2008 is not the perfect guide, merely a good example of what can go wrong. In 2008 the drawdowns on corporate lines were nowhere near what they were in previous crises, since corporates were already so cash rich. The question you need to ask is to what level should banks self-insure for a systemic crisis.

Just because there is a central bank doesn't mean that it can help out in time of a crisis.

If it is the banking arm that is under stress, yes then the central bank can help. If (and more likely) the stress is within the broker dealer the amount the central bank can do is pretty much zero. This is why the PDCF was created (and exemptions were granted to 23-A).

LCR is help the system get through the first 30 days of severe shock and de-leveraging.

Considering that liquidity regulation has absolutely sucked, and the current regulators do not understand how a broker dealer funds itself, the LCR actually does a pretty damn good job of conservatively covering risk of outflows that were experienced in 2008. That being said the regulators can only come up with stupid ratios (capital, liquidity etc). The only drawback of the ratio is all of your outflows could occur on day 2 and get the same result as if they were to occur on day 30. The duration of the liquidity should also be considered (the NSFR has the same drawback).

Allowing equities, bonds etc would certainly be a great improvement (at the right haircut, maybe even 50%) and for only a portion of the pool... the most important part is that IF you chose to have those assets in there, then there has to be a forced liquidation if your liquidity falls below a certain level. Otherwise the banks may not sell the assets at a distressed price.

98% is just purely laughable... if they are holding a borad based index, say SPY you are basically saying the S&P would drop to 25 from 1250?! At that point I think its safe to say we would beyond turmoil.

It's a pity that a fed reserve governor would be so reckless. Even triple AAA rated equities and companies have been shown hollow and at times worthless in recent years. This is another blow to the economy. When I say - the economy - I mean the hundreds of millions of people (globally) who will be hurt by liquidity crises in the future.

Why do you feel this way? By the way the ratings apply to the bonds , not the stocks.

What exactly do you mean by hallow? That the price may fluctuate wildly? Or that there is not a market for them? Even in 2008, there was always liquidity in the stock market, and that may not be true of say certain sov's today.

The price fluctuations may be something hard to deal with (but eqty derivatives could help) but at least there is always going to be liquidity. Especially if it were a broad based index ETF like SPY or DIA etc.

Again, the most important part is a mandated sale or liquidation so that companies don't hold them for two long

Equities do offer some diversification, but they add risk. Banks can hold investments that retain value with less risk, such as real estate and certain commodities. Equities might offer real value - but only in companies that are not leveraged. Therein lies the problem. How much is the equity you hold really worth. It could be worth $90 dollar a share one week and $9 dollars a share or 99 cents a share the next week. It's difficult to track down exactly how much a company is really leveraged because accountants (and bankers) have become so skilled at moving liabilities off the books. Companies that look sound on paper may be financially overleveraged. That's the risk with equities. You can't trust ratings companies to advise you on which equities will be sound. They can't do that. We saw that in 2008 (again). Ratings companies depend on the companies they rate for profits. Some analysts do work with integrity - but they also get a lot of grief for it. Remember "All the devils are here: The Hidden History of the Financial Crisis" by Bethany Maclean and Joe Nocera. Ratings companies are rife with conflicts of interests. If you can't trust the ratings on equities, how can you hold those equities for liquidity coverage?

ratings are on bonds. not equities. whats apples rating? they don't have one because they don't have any unsecured debt. The rating is supposed to the probability of default on debt, it has NOTHING to do with the stock of a company.

Cool, lets just accuse every company in america of fraud for hiding information off of their books. how exactly are they doing this by the way? Banks were certainly doing this by SIVs and other forms which I agree certainly corrupt and glad those practices are being cracked down on. How about companies like DIS, KO, PG etc?

Mortgages are a safe bet? Umm, wow. Yeah I am just going to touch that one, because your head has been in the sand the past 3 years I guess

Yes the prices of equities can fluctuate, but if you hedge them properly with an equity swap or derivative you can ensure some stability.

I am not advocated for banks to invest their entire excess into equities, rather a portion should be allowable.

The liquidity reserve should be like a diamond. At the top, the largest portion should be highly liquid and low yielding, as the diamond narrows the risk level should be allowed to increase a little bit. So if a company wants to hold 5-10 or even 15% of their cash reserves in equities fine.

Yes one stock may drop because of whatever reason, which is why they should have to hold broad based indices... Banks, just like everybody should still diversify

A previous commenter, Rupi, articulated the point I was hoping to make in a far better way. Rupi said an appropriate haircut would be 90 to 98% in a given day. Companies go bankrupt on a daily basis (and executives don't like to share when companies are ailing or the numbers do not look good). Maybe 98% is too high -- but I would strongly urge you to not discount the amount of risk involved. It's there.

When the goal is stability - a volatile investment may not be the best idea. [On the other hand - if corporate governance/exec. compensation were changed for public companies - tightening controls on executives and making the company finances more transparent - maybe equities could become less volatile and more appropriate as a safe holding).

yes agreed, on any given day a single company could file for bankruptcy and lose 98% of its value.

On any given day the S%P or Dow moves no more than 5% (10% MAX). That would be an absolutely catastrophic day.

The max drop in the Dow was something like 40-50% and that was over the course of a 1.5+years (late 2007 into early 2009) so I think it is possible for BROAD BASED INDICES to have value as part of liquidity.

Caution is one thing, saying every stock or diversified portfolio needs a 98% haircut is just idiotic.

The system clearly needs to be safer, more regulated with greater transparency. Knee jerk reactions will not help.

1) How do you determine a safe/large cap stock during economic crisis - so you might have all covered just few days before shit hits the fan and when it does you are suddenly lost again!2) Won't having large caps in your portfolio and necessity of either using it as collateral or selling them off create pressure on the stock itself...so say i am in trouble and i go dump some stock for cash..ur company is fine and suddenly u realise ur LCR is going down cause of sudden movement in stock3) won't this put artificial pressure on the company whose stock are being majorly held by companies in distress without there being any issue with the company itself!4) I understand that this could happen without having equities under LCR but still what kind of guidelines can prevent the above from happening

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I'm a finance lawyer in New York. I used to focus on derivatives and structured finance (you know, back when there was a structured finance market). I spent the majority of my career at one of the major investment banks. My background is in economics and, unfortunately, politics.

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